Armageddon in China?Observations on the stress in financial markets among other due to the economic slowdown in China, first drafted on Aug. 12, published on Aug. 21, 2015-------------------------------------------------------------------------------------------------------------------------------------------

Dramatic things are happening in the financial markets. China’s economy is losing steam to such an extent that People’s Bank of China had to devalue its currency in several breathtaking steps. Additionally markets are gripped by the fear that the FED might raise interest rates in September or December. Meanwhile, Europe is in the process of enacting Greece’s 3rd bail-out package; the emerging markets are hit hard by the new slump in oil and commodity prices; the US$ is appreciating substantially against most currencies but in particular those of the emerging markets and the Russell 2000 is already in correction territory. The million dollar question obviously is how much further will markets go down from here. Since this is a complex situation we like to throw out a couple of observations which hopefully will add up to a coherent conclusion in the end:

The drop in oil and commodity prices is here to stay for a couple of quarters due to overcapacity and slowing demand notably in China.

Obviously the drop in oil prices will help the chemical industry and consumers worldwide. But it will create a lot of pain for commodity exporting nations and those who sell machinery and other products to them (Germany, for instance).

The most important driver of the downward pressure on market valuations, however, is the slowdown in China. There are two open questions which largely determine the impact of that slowdown on the world economy. These questions are the following: a) Will the Chinese government succeed in stimulating exports and domestic growth by rigging the Shanghai stock market, by devaluating the Yuan and by firing away more of their foreign currency reserves? b) Will the slowdown reach proportions that might even affect the stability of the political system?

Let us look at question 4 a) first: The chances for stimulating growth in China through the devaluation of the Yuan are not bad. However this may very well be the only Keynesian tool that the Chinese government has left to get the economy on the 7% growth path it is shooting for. The fragility of the Chinese banking sector, the bubble in the construction industry and the shady state of finances of the state owned enterprises clearly limits the government’s options. Additionally, it is more than likely that the Chinese government itself will not have an untainted view on the real state of its economy due to stonewalling by local and regional government and due to internal rivalries within the leadership of the Communist Party. There can be no doubt that Chinese government is aware of its vulnerability. Its nervousness became apparent when the People’s Bank of China initially claimed that the August 11 devaluation would be a one-off move. We now know that it was anything but that.

Quite a few signals therefore point to the possibility of social unrest and political instability in China (4b). If that were to happen the world economy would suffer devastating consequences. At this time, markets don’t seem to factor in the threat of a Chinese Armageddon. If they would, the volatility index would be even higher than it is at this point. Nevertheless, one has to be cautious here. There can be no doubt that a political implosion in China will eventually happen. And due to the opaque nature of the Chinese mentality this implosion will come at a time when outside observers expect it the least. Pro-democracy campaigners, however should not fool themselves into thinking that such an implosion of the communist party rule would usher in a new era of freedom and democracy in China. It is our opinion that the Chinese society is more inclined to stick with an authoritarian political systems rather than opt for Western political model. In other words, the Chinese public may well be tired of the communist rule, but it isn’t tired of a top-down political system. The crushing of the Tiananmen protests and the ensuing rise of the Chinese economy will likely have demonstrated to the Chinese society that it is better off with a command and control system than with Western anarchy. All this leads us to believe that a political overthrow in the context of the current economy downturn is possible but not likely to happen this time around. We have reached this conclusion for two reasons: First, the memory of China’s glorious economic rise is still too fresh for the Chinese public to turn entirely against its current political leadership now. And secondly, if the implosion were to happen soon, the Euro currency would be one of its first victims. That in turn would thrash into pieces the historic efforts of the European Union to establish and safeguard a peaceful status quo on the old continent. It would be brutally unfair to all those good efforts in Europe if that were to happen. And since such a turn of events is simply unthinkable, we cannot imagine that it actually comes to pass.

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